The manager of the £70m Montanaro Equity Income fund says the increasing wariness of the global economic recovery and the stellar run of small caps in recent years have led to significant profit-taking from the asset class.
While the pace of outflows is slowing, he believes small caps are likely to underperform versus their large-cap counterparts until the New Year.
"Small caps have been getting killed in relative terms. Market timing is a mug's game, but money has been coming out of small caps,” he said.
Performance of sectors and indices since Mar 2014
Source: FE Analytics
“Over the past five years it seemed people forgot there was any risk in the market at all, but it's changed. You're going to have to work harder to make money now."
"I can see this happening for another three to six months. Valuations are now fair again but not cheap. We've been heading in the right direction, but I wouldn't rush in now.”
Montanaro says small caps got ahead of themselves in price-to-earnings terms last year, as the below graph shows.
Typically he says small caps have underperformed when they’ve reached a P/E of around 18 times, but at 14 times are now much closer to fair value.
P/E of UK small caps (12m trail) since 1979
Outflows from UK small caps have been at their highest since 2008, according to research by Montanaro and the IMA.
The manager believes the margin of underperformance versus large caps is most probably “coming to an end”, though points out that at certain times in history small caps have lagged by a much higher margin.
In 2008, for example, small caps underperformed their large cap counterparts by around 16 percentage points.
Since the highs of March this Numis index has underperformed the FTSE 100 by around 10 percentage points.
Typically underperformance by more than 3 percentage points has been a good time to buy small caps, Montanaro says, given how much better they have performed over the long term.
Performance of sectors and indices over 20yrs
Source: FE Analytics
Tim Cockerill, investment director at Rowan Dartington, believes that small caps have become more attractive in light of the recent sell-off, and thinks now could well be a good time for investors to top up their exposure.
He agrees that further short-term pain could be on the horizon however, and thinks a drip feeding strategy is most appropriate.
“We hold them in our aggressive models. Over the long-term we expect them to do well, and after a fantastic 2013, they have come a long way off,” said Cockerill, who highlights R&M UK Smaller Companies as his favourite fund in the sector.
“It’s always difficult to know when a fund has hit the bottom. I think the best strategy is to nibble away at them, because you could well see a further 5 to 10 per cent fall. If the German GDP number for the last quarter is negative you could see a further shock, and there are concerns over the end of QE in the US, which is an unknown entity.”
Cockerill points out investors who bought UK small caps too early in 2009 were still rewarded over the long-term, so doesn’t think investors should worry too much about timing the market perfectly.
“Small caps should never be bought with a short-term view in mind,” he added.
Montanaro Equity Income is one of the very few pure small cap funds operating in the IMA UK Equity Income sector, listing Unicorn UK Income, PFS Chelverton UK Equity Income, CF Miton Multi Cap Income and Marlborough Multi Cap Income as direct rivals.
With the Miton fund now soft-closed and many experts casting concern over the size of the remaining three, Montanaro could be seen as a possible alternative.
Like all small cap managers, Montanaro believes he has a fundamental edge over his large cap competitors, for the simple reason that his universe of stocks is less researched.
This, he says, has resulted in not only superior long-term returns but also better dividend growth.
Research from Numis shows that between 1955 and 2013, dividend growth for small caps was 8.1 per cent per year and only 6.6 per cent for large caps.
He and his team believe the sweet spot for a stockpicker is between £80m and £2.5bn – anything less is too illiquid and anything more too researched.
While small caps tend to be associated with high risk, Montanaro attempts to offset this by identifying quality, "blue chip-like" companies.
He targets business models that are easy to understand, usually niche and leaders in their respective markets, with high operating margins.
Major holdings include Cineworld, the second largest cinema operator in Europe, and Swedish company Loomis, which specialises in the collection, management and distribution of cash.
There are currently 41 stock positions, making it one of the more concentrated small cap portfolios.
Montanaro has run the fund since 2006, though changed its European mandate in February 2014, joining the IMA UK Equity Income sector in July.
Since joining the sector, the fund has lost 7.19 per cent, putting it slightly ahead of its Unicorn and Chelverton rivals but behind Marlborough and Miton.
Performance of funds and sector since July 2014
Source: FE Analytics
Unusually, Montanaro has decided to waive an annual charge for the £60m fund until it reaches £100m, meaning investors only have to pay for extra costs such as trading fees.
The AMC will be fixed at 0.75 per cent when the fund reaches this size.
